I mentioned the other day that it looks like things are turning up for a position that is long housing and short bonds. On the bond side, I expect long term rates to move up as housing begins to attract capital again, and short term rate expectations should move up as GDP growth accelerates. Short Eurodollar contracts in the early 2018 time frame seem like the best spot to target those movements. That time frame should capture most of those rate movements while avoiding unrelated Fed discretionary moves regarding the date of the first Fed Funds rate hike or the cyclical peak in the Fed Funds rate. On the other hand, if long term rates on housing and treasuries converge, generally, then there are probably more gains to be captured farther out on the yield curve as the entire curve moves higher. My main concern there would be that aggressive hawkish postures by the Fed could hold those rates down while leaving rates in the 2016-2018 time frame relatively unchanged or even higher. If the Fed somehow moves into a dovish position, long term rates and mid-term rates would rise, due to positive market conditions and inflation expectations, and this would also seem to favor that 2018 time frame.
Here's yesterday's graph of new home sales and home prices over time. We can see here how home sales have suddenly moved up sharply, but still have a long way to go (although housing starts have not seen this same sharp move up in the last couple of months). I have already noted that mortgages have begun to expand at the banks. I expect home price growth to begin to turn upward again, also. Note in this graph how home prices tend to lag home sales. This supports my general thesis that home prices are sticky, and that much of the speculative activity in the 2000s boom revolved around that. I had originally expected to be able to value homebuilders, in part, as land speculators. But, their business and their valuations seem to be much more closely tied to sales volume than price. I think this is partly because of this price stickiness issue. The outlet valve for housing when the equilibrium price is moving sharply is the new home builders. The quantity response moves through the homebuilders.
On the housing side, one way to take a position would be to take long exposure in a homebuilder that would be expected to gain the most from positive surprises in new home sales. Here are two earlier posts on the idea. Here, we really want to aim for a highly leveraged, high beta firm. In addition, homebuilders tend to be sitting on large amounts of tax assets, many of which are still off the balance sheets at the firms that have struggled the most through the housing bust. I had hoped to find a clever valuation method for these firms, specific to the situation. But, generally, it looks to me like the homebuilders tend to have a pretty stable ratio for Enterprise Value / Revenues of 1 or slightly higher. It tends to move up somewhat when growth expectations or margins are running high, but it appears to be a stable valuation metric for the industry as well as for individual firms.
In the next graph, homebuilder enterprise values are compared to current revenues and prospective revenues. My "bullish" 2016 revenue level here equates to 2 year growth of about 66%. That is similar to growth rates since 2012, and would put home sales in 2016 only back up to about the levels of the mid-1990s, so I don't think that is excessive in the current climate. And, that puts industry-wide valuations, with some modest annual gains, at the range of baseline valuation levels when growth might be expected to moderate in a few years.
Because growth rates seem to be somewhat priced in, I am not sure how much gain is available, industry-wide, for a bullish forecast. There might be 25% or more in industry-wide excess gains if my bullish forecast comes to fruition over the next 2 years, but I think the gains for the entire industry may be dependent on the length of time the recovery is allowed to run, and there is too much political/monetary uncertainty there for valuations to reflect hopeful growth more than a few years in advance. So, what industry-wide gains there may be may happen in real time as the recovery progresses.
For this first phase, I think the gains will come mostly from the more distressed firms. In these charts, the firms are arranged by leverage (red bars). Debt here is shorthand for Enterprise Value minus Market Capitalization. The blue bars reflect growth forecasts. Dark blue is revenue, and light blue is how that growth would flow to equity holders, given current leverage levels. Growth expectations are fairly tight across the industry, so the inferred equity growth is strongly related to leverage.
In the next chart, the measures are the expected market cap with an Ent.Value/Revenue ratio of 1 at 2014 revenue levels, 2016 forecasted levels, and my bullish 2016 levels. All values are as a percentage of the current market capitalization. All enterprise values have tax assets deducted (including off balance sheet allowances). We can see that the EV/Rev. value is somewhat lower than most of the market capitalizations of the more healthy builders, and for the industry as a whole. The builders who are highly leveraged are currently priced below that level. (For instance, Hovnanian (HOV) would need to nearly double in price for its Enterprise Value to equal its current revenues.) This makes sense, as the distress caused by the over-leveraged balance sheets creates added risk, so if a recovery does not come, these firms will likely suffer valuation losses. But, these are the firms which offer the most upside from a bullish market. And Hovnanian really is the firm most aligned to this proposal.
Betas for the firms also tend to follow the same pattern as the leverage levels, with Beazer, Hovnanian, and KB tending to have higher betas than the other equities. I think this is a case where extremes in potential outcomes and betas can make it difficult for theoretical models to apply to actual financial performance. Even Hovnanian tends to have a beta less than 2. I think part of what happens is that things like operating and financial leverage do create a multiplier effect as revenue ebbs and flows. But, additionally, the leverage also serves as a sort of optimization of a certain set of expectations about revenue growth. So, some of what is actually beta will be measured as alpha, depending on how optimized that firm's leverage is to actual revenue growth.
Statistically measured betas simply can't capture these nuances. Good timing in these matters can capture gains that market-wide statistical analysis won't find. Good timing ... that should be easy. I mean, what could be so hard about that?